Corporate finance is an area of finance dealing with the
financial decisions corporations make and the tools and analysis
used to make these decisions
CORPORATE FINANCE
Corporate finance is an area of finance dealing with the
financial decisions corporations make and the tools and analysis
used to make these decisions. The primary goal of corporate finance
is to maximize corporate value while managing the firm's financial
risks. Although it is in principle different from managerial
finance which studies the financial decisions of all firms, rather
than corporations alone, the main concepts in the study of
corporate finance are applicable to the financial problems of all
kinds of firms.
The discipline can be divided into long-term and short-term
decisions and techniques. Capital investment decisions are
long-term choices about which projects receive investment, whether
to finance that investment with equity or debt, and when or whether
to pay dividends to shareholders. On the other hand, the short term
decisions can be grouped under the heading "Working capital
management". This subject deals with the short-term balance of
current assets and current liabilities; the focus here is on
managing cash, inventories, and short-term borrowing and lending
(such as the terms on credit extended to customers).
The terms Corporate finance and Corporate financier are also
associated with investment banking. The typical role of an
investment banker is to evaluate company's financial needs and
raise the appropriate type of capital that best fits those
needs.
1 Capital investment decisions
1.1 The investment decision
1.1.1 Project valuation
1.1.2 Valuing flexibility
1.1.3 Quantifying uncertainty
1.2 The financing decision
1.3 The dividend decision
1. Capital investment decisions
Capital investment decisions [1] are long-term corporate finance
decisions relating to fixed assets and capital structure. Decisions
are based on several inter-related criteria. Corporate management
seeks to maximize the value of the firm by investing in projects
which yield a positive net present value when valued using an
appropriate discount rate. These projects must also be financed
appropriately. If no such opportunities exist, maximizing
shareholder value dictates that management return excess cash to
shareholders. Capital investment decisions thus comprise an
investment decision, a financing decision, and a dividend
decision.
1.1 The investment decision
Main article: Capital budgeting
Management must allocate limited resources between competing
opportunities ("projects") in a process known as capital budgeting.
Making this capital allocation decision requires estimating the
value of each opportunity or project: a function of the size,
timing and predictability of future cash flows.
1.1.1Project valuation
Further information: stock valuation and fundamental
analysis
In general, each project's value will be estimated using a
discounted cash flow (DCF) valuation, and the opportunity with the
highest value, as measured by the resultant net present value (NPV)
will be selected (applied to Corporate Finance by Joel Dean in
1951; see also Fisher separation theorem, John Burr Williams:
Theory). This requires estimating the size and timing of all of the
incremental cash flows resulting from the project. These future
cash flows are then discounted to determine their present value
(see Time value of money). These present values are then summed,
and this sum net of the initial investment outlay is the NPV.
The NPV is greatly affected by the discount rate. Thus selecting
the proper discount ratethe project "hurdle rate"is critical to
making the right decision. The hurdle rate is the minimum
acceptable return on an investmenti.e. the project appropriate
discount rate. The hurdle rate should reflect the riskiness of the
investment, typically measured by volatility of cash flows, and
must take into account the financing mix. Managers use models such
as the CAPM or the APT to estimate a discount rate appropriate for
a particular project, and use the weighted average cost of capital
(WACC) to reflect the financing mix selected. (A common error in
choosing a discount rate for a project is to apply a WACC that
applies to the entire firm. Such an approach may not be appropriate
where the risk of a particular project differs markedly from that
of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used
as (secondary) selection criteria in corporate finance. These are
visible from the DCF and include discounted payback period, IRR,
Modified IRR, equivalent annuity, capital efficiency, and ROI; see
list of valuation topics.
1.1.2 Valuing flexibility
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open
(or close) paths of action to the company, but this reality will
not typically be captured in a strict NPV approach. Management will
therefore (sometimes) employ tools which place an explicit value on
these options. So, whereas in a DCF valuation the most likely or
average or scenario specific cash flows are discounted, here the
flexibile and staged nature of the investment is modelled, and
hence "all" potential payoffs are considered. The difference
between the two valuations is the "value of flexibility" inherent
in the project.
The two most common tools are Decision Tree Analysis (DTA) and
Real options analysis (ROA); they may often be used
interchangeably:
DTA values flexibility by incorporating possible events (or
states) and consequent management decisions. In the decision tree,
each management decision in response to an "event" generates a
"branch" or "path" which the company could follow; the
probabilities of each event are determined or specified by
management. Once the tree is constructed: (1) "all" possible events
and their resultant paths are visible to management; (2) given this
knowledge of the events that could follow, management chooses the
actions corresponding to the highest value path probability
weighted; (3) (assuming rational decision making) this path is then
taken as representative of project value. See Decision theory:
Choice under uncertainty. (For example, a company would build a
factory given that demand for its product exceeded a certain level
during the pilot-phase, and outsource production otherwise. In
turn, given further demand, it would similarly expand the factory,
and maintain it otherwise. In a DCF model, by contrast, there is no
"branching" - each scenario must be modelled separately.)
ROA is usually used when the value of a project is contingent on
the value of some other asset or underlying variable. Here, using
financial option theory as a framework, the decision to be taken is
identified as corresponding to either a call option or a put option
- valuation is then via the Binomial model or, less often for this
purpose, via Black Scholes; see Contingent claim valuation. The
"true" value of the project is then the NPV of the "most likely"
scenario plus the option value. (For example, the viability of a
mining project is contingent on the price of gold; if the price is
too low, management will abandon the mining rights, if sufficiently
high, management will develop the ore body. Again, a DCF valuation
would capture only one of these outcomes.)
1.1.3 Quantifying uncertainty
Further information: Sensitivity analysis, Scenario planning,
and Monte Carlo methods in finance
Given the uncertainty inherent in project forecasting and
valuation, analysts will wish to assess the sensitivity of project
NPV to the various inputs (i.e. assumptions) to the DCF model. In a
typical sensitivity analysis the analyst will vary one key factor
while holding all other inputs constant, ceteris paribus. The
sensitivity of NPV to a change in that factor is then observed
(calculated as NPV / factor). For example, the analyst will set
annual revenue growth rates at 5% for "Worst Case", 10% for "Likely
Case" and 25% for "Best Case" and produce three corresponding
NPVs.
Using a related technique, analysts may also run scenario based
forecasts so as to observe the value of the project under various
outcomes. Under this technique, a scenario comprises a particular
outcome for economy-wide, "global" factors (exchange rates,
commodity prices, etc...) as well as for company-specific factors
(revenue growth rates, unit costs, etc...). Here, extending the
example above, key inputs in addition to growth are also adjusted,
and NPV is calculated for the various scenarios. Analysts then plot
these results to produce a "value-surface" (or even a
"value-space"), where NPV is a function of several variables.
Another application of this methodology is to determine an
"unbiased NPV", where management determines a (subjective)
probability for each scenario the NPV for the project is then the
probability-weighted average of the various scenarios. Note that
for scenario based analysis, the various combinations of inputs
must be internally consistent, whereas for the sensitivity approach
these need not be so.
A further advancement is to construct stochastic or
probabilistic financial models as opposed to the traditional static
and deterministic models as above. For this purpose, the most
common method is to use Monte Carlo simulation to analyze the
projects NPV. This method was introduced to finance by David B.
Hertz in 1964, although has only recently become common; today
analysts are even able to run simulations in spreadsheet based DCF
models, typically using an add-in, such as Crystal Ball.
Using simulation, the cash flow components that are (heavily)
impacted by uncertainty are simulated, mathematically reflecting
their "random characteristics". In contrast to the scenario
approach above, the simulation produces several thousand trials
(i.e. random but possible outcomes) and the output is a histogram
of project NPV. The average NPV of the potential investment as well
as its volatility and other sensitivities is then observed. This
histogram provides information not visible from the static DCF: for
example, it allows for an estimate of the probability that a
project has a net present value greater than zero (or any other
value). See: Monte Carlo Simulation versus What If Scenarios.
Here, continuing the above example, instead of assigning three
discrete values to revenue growth, the analyst would assign an
appropriate probability distribution (commonly triangular or beta).
This distribution and that of the other sources of uncertainty
would then be "sampled" repeatedly so as to generate the several
thousand realistic (but random) scenarios, and the output is a
realistic, representative set of valuations. The resultant
statistics (average NPV and standard deviation of NPV) will be a
more accurate mirror of the project's "randomness" than the
variance observed under the traditional scenario based
approach.
1.2 The financing decision Main article: Capital
structureAchieving the goals of corporate finance requires that any
corporate investment be financed appropriately. As above, since
both hurdle rate and cash flows (and hence the riskiness of the
firm) will be affected, the financing mix can impact the valuation.
Management must therefore identify the "optimal mix" of
financingthe capital structure that results in maximum value. (See
Balance sheet, WACC, Fisher separation theorem; but, see also the
Modigliani-Miller theorem.)
The sources of financing will, generically, comprise some
combination of debt and equity. Financing a project through debt
results in a liability that must be servicedand hence there are
cash flow implications regardless of the project's success. Equity
financing is less risky in the sense of cash flow commitments, but
results in a dilution of ownership and earnings. The cost of equity
is also typically higher than the cost of debt (see CAPM and WACC),
and so equity financing may result in an increased hurdle rate
which may offset any reduction in cash flow risk.
Management must also attempt to match the financing mix to the
asset being financed as closely as possible, in terms of both
timing and cash flows.
One of the main theories of how firms make their financing
decisions is the Pecking Order Theory, which suggests that firms
avoid external financing while they have internal financing
available and avoid new equity financing while they can engage in
new debt financing at reasonably low interest rates. Another major
theory is the Trade-Off Theory in which firms are assumed to
trade-off the tax benefits of debt with the bankruptcy costs of
debt when making their decisions. An emerging area in finance
theory is right-financing whereby investment banks and corporations
can enhance investment return and company value over time by
determining the right investment objectives, policy framework,
institutional structure, source of financing (debt or equity) and
expenditure framework within a given economy and under given market
conditions. One last theory about this decision is the Market
timing hypothesis which states that firms look for the cheaper type
of financing regardless of their current levels of internal
resources, debt and equity.
1.3 The dividend decision Main article: The Dividend DecisionThe
dividend is calculated mainly on the basis of the company's
unappropriated profit and its business prospects for the coming
year. If there are no NPV positive opportunities, i.e. where
returns exceed the hurdle rate, then management must return excess
cash to investors. These free cash flows comprise cash remaining
after all business expenses have been met.
This is the general case, however there are exceptions. For
example, investors in a "Growth stock", expect that the company
will, almost by definition, retain earnings so as to fund growth
internally. In other cases, even though an opportunity is currently
NPV negative, management may consider investment flexibility /
potential payoffs and decide to retain cash flows; see above and
Real options.
Management must also decide on the form of the distribution,
generally as cash dividends or via a share buyback. There are
various considerations: where shareholders pay tax on dividends,
companies may elect to retain earnings, or to perform a stock
buyback, in both cases increasing the value of shares outstanding;
some companies will pay "dividends" from stock rather than in cash;
see Corporate action. Today, it is generally accepted that dividend
policy is value neutral (see Modigliani-Miller theorem).
2 Working capital management
2.1 Decision criteria
2.2 Management of working capital
2.Working capital management Main article: Working
capitalDecisions relating to working capital and short term
financing are referred to as working capital management. These
involve managing the relationship between a firm's short-term
assets and its short-term liabilities.
As above, the goal of Corporate Finance is the maximization of
firm value. In the context of long term, capital investment
decisions, firm value is enhanced through appropriately selecting
and funding NPV positive investments. These investments, in turn,
have implications in terms of cash flow and cost of capital.
The goal of Working capital management is therefore to ensure
that the firm is able to operate, and that it has sufficient cash
flow to service long term debt, and to satisfy both maturing
short-term debt and upcoming operational expenses. In so doing,
firm value is enhanced when, and if, the return on capital exceeds
the cost of capital; See Economic value added (EVA).
2.1 Decision criteria
Working capital is the amount of capital which is readily
available to an organization. That is, working capital is the
difference between resources in cash or readily convertible into
cash (Current Assets), and cash requirements (Current Liabilities).
As a result, the decisions relating to working capital are always
current, i.e. short term, decisions.
In addition to time horizon, working capital decisions differ
from capital investment decisions in terms of discounting and
profitability considerations; they are also "reversible" to some
extent. (Considerations as to Risk appetite and return targets
remain identical, although some constraints - such as those imposed
by loan covenants - may be more relevant here).
Working capital management decisions are therefore not taken on
the same basis as long term decisions, and different criteria are
applied here: the main considerations are cash flow and liquidity -
cashflow is probably the more important of the two.
The most widely used measure of cash flow is the net operating
cycle, or cash conversion cycle. This represents the time
difference between cash payment for raw materials and cash
collection for sales. The cash conversion cycle indicates the
firm's ability to convert its resources into cash. Because this
number effectively corresponds to the time that the firm's cash is
tied up in operations and unavailable for other activities,
management generally aims at a low net count. (Another measure is
gross operating cycle which is the same as net operating cycle
except that it does not take into account the creditors deferral
period.)
In this context, the most useful measure of profitability is
Return on capital (ROC). The result is shown as a percentage,
determined by dividing relevant income for the 12 months by capital
employed; Return on equity (ROE) shows this result for the firm's
shareholders. As above, firm value is enhanced when, and if, the
return on capital, exceeds the cost of capital. ROC measures are
therefore useful as a management tool, in that they link short-term
policy with long-term decision making.
2.2 Management of working capital
Guided by the above criteria, management will use a combination
of policies and techniques for the management of working capital.
These policies aim at managing the current assets (generally cash
and cash equivalents, inventories and debtors) and the short term
financing, such that cash flows and returns are acceptable.
Cash management. Identify the cash balance which allows for the
business to meet day to day expenses, but reduces cash holding
costs.
Inventory management. Identify the level of inventory which
allows for uninterrupted production but reduces the investment in
raw materials - and minimizes reordering costs - and hence
increases cash flow; see Supply chain management; Just In Time
(JIT); Economic order quantity (EOQ); Economic production quantity
(EPQ).
Debtors management. Identify the appropriate credit policy, i.e.
credit terms which will attract customers, such that any impact on
cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa); see
Discounts and allowances.
Short term financing. Identify the appropriate source of
financing, given the cash conversion cycle: the inventory is
ideally financed by credit granted by the supplier; however, it may
be necessary to utilize a bank loan (or overdraft), or to "convert
debtors to cash" through "factoring".
3 Financial risk management
3.Financial risk management Main article: Financial risk
managementRisk management is the process of measuring risk and then
developing and implementing strategies to manage that risk.
Financial risk management focuses on risks that can be managed
("hedged") using traded financial instruments (typically changes in
commodity prices, interest rates, foreign exchange rates and stock
prices). Financial risk management will also play an important role
in cash management.
This area is related to corporate finance in two ways. Firstly,
firm exposure to business risk is a direct result of previous
Investment and Financing decisions. Secondly, both disciplines
share the goal of creating, or enhancing, firm value. All large
corporations have risk management teams, and small firms practice
informal, if not formal, risk management.
Derivatives are the instruments most commonly used in Financial
risk management. Because unique derivative contracts tend to be
costly to create and monitor, the most cost-effective financial
risk management methods usually involve derivatives that trade on
well-established financial markets. These standard derivative
instruments include options, futures contracts, forward contracts,
and swaps.
See: Financial engineering; Financial risk; Default (finance);
Credit risk; Interest rate risk; Liquidity risk; Market risk;
Operational risk; Volatility risk; Settlement risk.
4 Relationship with other areas in finance
4.1 Investment banking
4.2 Personal and public finance4.Relationship with other areas
in finance
4.1 Investment banking
Use of the term corporate finance varies considerably across the
world. In the United States it is used, as above, to describe
activities, decisions and techniques that deal with many aspects of
a companys finances and capital. In the United Kingdom and
Commonwealth countries, the terms corporate finance and corporate
financier tend to be associated with investment banking - i.e. with
transactions in which capital is raised for the corporation.4.2
Personal and public finance
Corporate finance utilizes tools from almost all areas of
finance. Some of the tools developed by and for corporations have
broad application to entities other than corporations, for example,
to partnerships, sole proprietorships, not-for-profit
organizations, governments, mutual funds, and personal wealth
management. But in other cases their application is very limited
outside of the corporate finance arena. Because corporations deal
in quantities of money much greater than individuals, the analysis
has developed into a discipline of its own. It can be
differentiated from personal finance and public finance.
5 Related professional qualifications
5. Related professional qualifications
Qualifications related to the field include:
Finance qualifications:
Degrees: Masters degree in Finance (MSF), Master of Financial
Economics
Certifications: Chartered Financial Analyst (CFA), Corporate
Finance Qualification (CF), Certified International Investment
Analyst(CIIA), Association of Corporate Treasurers (ACT), Certified
Market Analyst (CMA/FAD) Dual Designation, Master Financial Manager
(MFM), Master of Finance & Control (MFC), Certified Treasury
Professional (CTP) Association for Financial Professionals.
Business qualifications:
Degrees: Master of Business Administration (MBA), Master of
Commerce (M Comm), Doctor of Business Administration (DBA)
Certifications: Certified Business Manager (CBM), Certified MBA
(CMBA)
Accountancy qualifications:
Qualified accountant: Certified Public Accountant (CPA),
Chartered Certified Accountant (ACCA), Chartered Management
Accountant (CIMA), Chartered Accountant (ACA)
Non-statutory qualifications: Chartered Cost Accountant (CCA
Designation from AAFM), Certified Management Accountant (CMA),
INTRODUCTION TO CORPORATE FINANCECorporate finance has two basic
functions:-
Acquisition of Resources
Acquisition of resource means fund generation at lowest possible
cost. Resource generation can be done through :-
Equity --- It includes proceeds obtained from stock selling,
retained earnings, and investment returns.
Liability --- It includes bank loans, warranties of products and
payable account.
Allocation of Resources
Investment of funds for profit maximization motive is known as
allocation of resources. Investment can be categorized into two
groups :-
Fixed Asset --- Land, Machinery, buildings, etc.
Current Asset --- Inventory, cash, receivable accounts, etc.
Corporate or business finance is all about raising and
allocation of funds for increasing profit. Senior management chalks
out long-term plan for fulfilling future objectives. Value of the
company's stock is a very important issue for the management
because it is directly related to the wealth of the share-holders
of the company. Functions of Corporate Finance are :-
Raising of Capital or Financing Budgeting of Capital Corporate
Governance Financial management Risk Management
All the above functions are interrelated and interdependent. For
example, in order to materialize a project a company needs to raise
capital. So, budgeting of capital and financing are
interdependent.
Decision making of the corporate finance are basically of two
types based on the time period for the same, namely, Long term and
Short term.
i . Long term decisions :-
It is basically concerned with the capital investment decisions
such as viability assessment of the project, financing it through
equity or debt, pay dividend or reinvest out of the profit. Long
term Corporate finance which are generally related to fixed assets
and capital structure are called Capital Investment Decisions.
Senior managements always target to maximize the value of the firm
by investing in positive NPV (Net Present Value) projects. If such
opportunities don't arise then reinvestment of profits should be
stalled and the excess cash should be returned to the shareholders
in the form of dividends. Hence, Capital Investment Decisions
constitute three decisions:-
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Decision on Investment Decision on Financing Decision on
Dividend
ii. Short term decisions :-
These are also known as working capital management which tries
to strike a balance between current assets (cash, inventories,
etc.) and current liabilities (a company's debts or obligations
impending for less than one year). Corporate finance is slightly
different from the accounting one. This can be understood by the
help of the following example:-
A Steel firm sells steel to a car manufacturer at $100 per ounce
(suppose) but has not received the payment for the same. Let the
Steel firm's cost of production be $90. Now, according to the
accounting rule the profit will be calculated as $(100-90) = $10
per ounce. But according to Corporate Finance the calculation
specifications will be :-
Inflow of Cash = 0
Outflow of Cash = -90
Corporate Financial Services
To keep the financial wheels moving, corporate finance services
are provided to by the corporate finance companies. One way of
providing corporate finance service is by asset based business
loans. Business loans are also used to improve cash flow,
restructuring the business, debt consolidation and as working
capital.
The financial services offered by the corporate finance company
may be discussed in detail under the following heads:
Asset Based Lending
Asset based financing is the method of obtaining loans by
keeping assets as security. The corporate company can use either
liquid, current assets or fixed asset as collateral to obtain the
asset based corporate finance service. The volume of the
asset-based finances is a function of the value of the underlying
asset that is used as the collateral. The asset-based lenders are
known as the secured lenders. The asset-based finances provide the
following corporate finance solutions:
The Asset based lending is used at the time of merger,
acquisition or buy out.
The Asset based lending is used for debt restructuring and
commercial refinancing. The Asset Based Lending is used to meet the
working capital needs.
Cash Flow Lending
Cash lending need can arise in response to seasonal
requirements, business expansion or cyclical business swings. The
cash flow financing experts can share their knowledge and expertise
to help in the cash flow management. The cash flow financing
instruments provide the following corporate finance solutions:
Cash flow lending is required at the time of acquisition, merger
or buy out.
Cash flow lending is required to meet working capital needs.
Cash flow lending is required to meet mezzanine financing,
recapitalization and spin-offs.
Second Lien Loans
The second Lien Loans are also known as Secondary Collateralized
Institutional Loans used mainly for recapitalization.
Recapitalization is the process of drawing out dividends and
substituting the more expensive mezzanine with the less expensive
SCIL financing and buying out financing. The SCIL is a much more
flexible corporate finance service as compared to mezzanine and
other corporate capital solutions.
The Secondary Collateralized Institutional Loans provide the
following corporate financial solutions:
Recapitalization
Refinancing
Corporate Debt Restructuring
This corporate financial service is meant to clear the past debt
burden. Debt Restructuring adds gives a different and new look to
the company. Business restructuring can be done by the use of cash
flow provided by commercial refinancing.
For proper corporate debt restructuring the following corporate
financial solutions are provided:
Asset based loans are provided for Corporate Debt
Restructuring.
Debtor-in -possession financing is provided for Corporate Debt
Restructuring.
Plan of Reorganization Financing is provided for Corporate Debt
Restructuring
Revolving Credit Facilities are provided for Corporate Debt
Restructuring.
Senior Secured Debt is provided for Corporate Debt
Restructuring.
The corporate finance solutions as mentioned earlier may be
explained as follows:
Acquisition, merger and buy out financing: Such corporate
finance services are lent out to companies who wish to leverage the
economies of scale, new technologies or choose to enter into new
markets. Different financial packages are available, like the Asset
based lending and cash flow loans to meet such ends.
Business Debt consolidation financing: This corporate financial
service helps to restructure business by refinancing past term and
equipment loans to match cash flow. Growth and working capital
needs : Working capital needs may arise from the desire to expand
business, globalize or updating infrastructure. The different
corporate finance services are available to fulfill these
desires.
Corporate Debt Restructuring and commercial refinancing :
Corporate debt Restructuring helps to clear the past debt and adds
new spirit to the company. Commercial refinancing is no longer the
best method of corporate debt restructuring but other methods like
the asset based lending, revolving loan facilities, term loans and
senior debt are much more valuable.
Corporate Financial Management
Corporate financial management deals with managing the working
capital of the company. it includes issues such as cash management,
inventory management, debtor's management and short term financing.
Each of these means of corporate financial management can be
discussed in detail under the following heads:
Cash Management Cash management services are offered by banks to
the large corporate bodies. The cash management services required
for corporate financial management are listed as follows:
1.Account Reconcilement Services : It becomes very difficult for
companies to keep track of cheques that have cleared and that have
not. Any error in this respect may not project the true balance
situation. To avoid this problem, banks maintain a list of cheques
that have cleared and those that have not. This process is known as
positive pay.
2.Advanced Web Services: The online services offered by many
banks help in the corporate financial management.
3.Armored Car Services : Banks assume the responsibility of
picking the cash on behalf of the large retailers who collect huge
cash volumes.
4.Automated Clearing House : This is an electronic system used
by companies to pay to its employees.
5.Balance Reporting Services : The companies subscribe to the
websites of the banks that inform the company regularly about its
account and cash position.
Sweep Accounts: In the case of any excess fund in the company's
bank account, the extra amount is shifted to the money market
mutual fund overnight and again moved back the next morning.
6.Zero Balance Accounting : By this system each store of a
company is given a specific account and money accumulated from all
these stores are transferred to the main account of the bank.
7.Inventory Management: Inventory management is yet another mode
of this whereby the company manages the inventory so that
production may continue uninterruptedly. This is done by minimizing
further investments in raw materials and reordering costs so as to
maximize cash flow.
8.Debtors management : It is essential to formulate a proper
credit policy so as to attract the customers. It should be so
designed so as to nullify any effect on the cash conversion cycle
and the cash flows by increased revenue.
ii. Short term financing: Bank loans are availed for the purpose
of short term financing
Financial risk management: Another aspect of this is the
corporate risk management. The following tools are used for the
financial risk management:
Futures : The futures contract is standardized contract, which
is traded on a futures exchange. It is designed to buy or sell an
underlying asset at a specific date and time. The buyer or seller
of the futures contract is obliged to fulfill the terms of the
contract.
Options : the options contract is almost the same as the futures
contract with the exception that the contract holder has the choice
to exercise the contract. There are two types of contracts- the
call option and the put option. Options are traded through a
clearinghouse. The buyer of the option is said to take the long
position while the seller is considered to take the short
position..
Investment banking : This is yet another method of corporate
financial management. The role of the investment bank is to issue
and sell securities in the primary market on behalf of the
international companies. They raise capital for the international
corporations through debt and equity.
Hedge Funds : Hedge funds are basically investment funds, which
charge a performance fee. Hedge funds are different from the mutual
funds, pension funds and insurance companies. Hedge funds can deal
with the futures, swaps and other derivative markets.
Private Equity : The private equity is any equity investment
that cannot be traded in the public markets. There are various
categories of private equity investment. They are:
Leveraged Buyout : Leveraged Buyout occurs when a financial
sponsor has control over the company's majority equity through the
use of debt.
Venture Capital: the professionals, institutionally backed by
outside investors to the new and nascent businesses, give this type
of private equity capital.
Growth Capital: The money that is borrowed under the Growth
Capital is used for any corporate purpose.
Angel investing : this is the method of investment by a very
financially well off individual in lieu of ownership equity.
Mezzanine capital: This is a wide term meant to cover unsecured,
high yield, subordinated and preferred stock.
Principle of Corporate Finance
Principle of Corporate Finance constitutes the theories and
their implementations by the managers of the companies in the
practical field for maximization of profit. Corporate Finance deals
with a company's financial or monetary activity (promotion,
financing, investment, organization, capital budgeting etc.). All
these activities are accomplished with the sole objective of profit
maximization. For meeting the fund requirements for any project of
a corporation, a company can get it from various sources such as
internal, external or equities at the lowest cost possible. This
fund is then used for investment purposes for the production of the
desirable asset.
Principle of Corporate Finance shows how the different corporate
financial theories help to formulate the policies for the growth of
a company. Finance is a science of managing money and other assets.
It is the process of channelization of funds in the form of
invested capital, credits, or loans to those economic agents who
are in need of funds for productive investments or otherwise. E.g.
On one hand, the consumers, business firms, and governments need
funds for making their expenditures, pay their debts, or complete
other transactions. On the other hand, savers accumulate funds in
the form of savings deposits, pensions, insurance claims, savings
or loan shares, etc which becomes a source of investment funds.
Here, finance comes to the fore by channeling these savings into
proper channels of investment.
Broadly, finance can be classified into three fields:-
Public Sector Finance: Financing in the government or public
level is known as public sector finance. Government meets its
expenditures mainly through taxes. Government budget generally
don't balance, hence it has to borrow for these deficits which in
turn gives rise to public debt.
Corporate or Business Finance: It tries to optimize the goals
(profit, sales, etc.) of a corporation or other business
organization by estimating future asset requirements and then
allocating funds in accordance to the availability of funds.
Personal Finance: It basically deals with the optimization of
finances in the individual (single consumer, family, personal
savings, etc.) level subjected to the budget constraint. E.g. A
consumer can finance his/her purchase of a car by taking a loan
from any bank or financial institutions.
Corporate or business finance is all about raising and
allocation of funds for increasing profit. Senior management chalks
out long-term plan for fulfilling future objectives. Value of the
company's stock is a very important issue for the management
because it is directly related to the wealth of the share-holders
of the company.
Some of the terms important in principle of Corporate finance
are:-
Net Present Value (NPV) Net Present Value = (Present Value of
Inflow of Cash) (Present Value of Outflow of Cash) NPV helps to
measure the value of a currency today with that of the future,
after taking into consideration returns and inflation. Positive Net
Present Value for a project means that the project is viable
because cash flows will be positive for the same. Senior
managements always target to maximize the value of the firm by
investing in positive NPV (Net Present Value) projects. If such
opportunities don't arise then reinvestment of profits should be
stalled and the excess cash should be returned to the shareholders
in the form of dividends.
Financial Risk management
According to Financial Economics, those projects which increases
the value of the shareholders wealth should be taken on. Financial
Risk Management is the creation of value of the shareholders of a
firm by managing the exposure to risk by the use of financial
instruments (loans, deposits, bonds, equity stocks, future and
options, etc.). Financial risk management involves :-
Identification of the source of risk Risk measurement Chalking
out of plans to manage the risks Financial Risk Management always
tries to find out viable opportunity to hedge the costly risk
exposures by using financial instruments.
Global Corporate Finance
Global corporate finance deals with global cross border funding
of various corporations. Global Corporate Finance follows a global
lending program by taking into consideration the tax and foreign
exchanges consequences.
The services provided by the global corporate finance are as
follows:
Payables Financing
Companies, which are availing the global corporate finance,
enjoy early payment discounts from customers. The financial
institutions that provide the global corporate finance open an
account with each of the suppliers giving them the option of
receiving payments as soon as possible. As time comes the suppliers
get paid through their account.
Inventory Financing In order to maintain a regular flow of cash,
100% inventory financing is provided to the companies availing this
service. The consumers who opt for inventory financing enjoy the
following benefits:
Increased credit capacity
Free financing for the sponsored suppliers
Simple and common repayment dates each month
100% advance rates
Online account management
Match repayment terms to accounts receivable terms have flexible
structures
Accelerated cash flow
Maximized business volumes
Improved days payables outstanding
Receivables financing
The most relevant part of a growing company is cost management
of higher accounts receivable and inventory level. The asset based
finance solutions offered under the global corporate finance
provide working capital for the growth of the company. The
revolving line of credit helps to obtain cash advances by using the
accounts receivable and inventory. Under this finances are provided
by following 3 steps:
Checking the eligibility of clients to receive it
Purchasing the receivables at a discount or for cash
Collecting the full invoice amount from the customers over
time.
The benefits attached with receivables financing are:
Acceleration of cash flow
Mitigation of collection risk
Enhancing productivity
Outsourcing collection activity
Optimization of asset potential.
Term loans
Term loan financing is generally coupled with other commercial
financing offering. This sort of financing is made to help in the
purchase of equipments and other important assets. The benefits of
term loans include:
Additional source of business finance
The spread of the cost of assets and infrastructure investments
over time.
Flexible Credit Scheme it provides flexible credit to the
customers. The advantages of a flexible credit regime is:
No interest payments are required for the financing periods
30,45 or 60 days
The principle can be repaid at the end of the free period.
CORPORATE FINANCE INDIA
This site provides comprehensive information on Corporate
Finance India. It also focuses on types of services offered by
Corporate Financing Community in India. The economic renaissance in
the 1990s brought by liberation of Indian economy had a stupendous
effect on the financial health of India. The Indian financial
market which was previously insulated from foreign investors were
thrown open for foreign investments. And with modern economic
policies (at par with western countries) in operation large quantum
of foreign direct investments / FDI started to flow into the Indian
market. The rise in business activities and its subsequent rise in
financial activities led to the need of proper and accurate
financing for corporates in India. Corporate Finance India provides
businessman, investors and entrepreneurs with finance and advice
for proper and risk free investments with an eye for maximum
returns. Corporate Finance India community relies on ready-to-use
data, projections and informations on India's economy. The
projections / future-movements of the financial market are based on
information and data collected from daily activities of the finance
market. Corporate Financiers in India advices their clients after
taking into consideration financial environment of the market along
with important decisions taken by the Government which, compliments
the financial health of the country.
Corporate Finance India focuses on the provision of corporate
advice and funding for Indian companies who wish to take advantage
of the liquidity of the Indian financial markets. Corporate Finance
India provides the following services to the Indian Corporate
Markets.
Corporate Finance .
Debt and equity funding.
Start up and Growth capital.
Pre-IPO finance.
Real Estate Sales and Acquisition.
Company Sales and Acquisitions.
Corporate Finance India focus has been on entrepreneurial
clients, whether individuals or businesses, and on providing
funding and investment in entrepreneurial businesses. Corporate
Finance India offers a complete solution to its clients objectives
through market research. Corporate Finance India companies has an
extensive network of investors and funding institutions and group
of corporate associates. The Corporate Finance India community
offers professional, personalized service and expertise both
responsively and pro-actively.
Corporate Finance
Arguably, the role of a corporation's management is to increase
the value of the firm to its shareholders while observing
applicable laws and responsibilities. Corporate finance deals with
the strategic financial issues associated with achieving this goal,
such as how the corporation should raise and manage its capital,
what investments the firm should make, what portion of profits
should be returned to shareholders in the form of dividends, and
whether it makes sense to merge with or acquire another firm.
Balance Sheet Approach to ValuationIf the role of management is
to increase the shareholder value, then managers can make better
decisions if they can predict the impact of those decisions on the
firm's value. By observing the difference in the firm's equity
value at different points in time, one can better evaluate the
effectiveness of financial decisions. A rudimentary way of valuing
the equity of a company is simply to take its balance sheet and
subtract liabilities from assets to arrive at the equity value.
However, this book value has little resemblance to the real value
of the company. First, the assets are recorded at historical costs,
which may be much greater than or much less their present market
values. Second, assets such as patents, trademarks, loyal
customers, and talented managers do not appear on the balance sheet
but may have a significant impact on the firm's ability to generate
future profits. So while the balance sheet method is simple, it is
not accurate; there are better ways of accomplishing the task of
valuation.
Cash vs. Profits
Another way to value the firm is to consider the future flow of
cash. Since cash today is worth more than the same amount of cash
tomorrow, a valuation model based on cash flow can discount the
value of cash received in future years, thus providing a more
accurate picture of the true impact of financial decisions.
Decisions about finances affect operations and vice versa; a
company's finances and operations are interrelated. The firm's
working capital flows in a cycle, beginning with cash that may be
converted into equipment and raw materials. Additional cash is used
to convert the raw materials into inventory, which then is
converted into accounts receivable and eventually back to cash,
completing the cycle. The goal is to have more cash at the end of
the cycle than at the beginning.
The change in cash is different from accounting profits. A
company can report consistent profits but still become insolvent.
For example, if the firm extends customers increasingly longer
periods of time to settle their accounts, even though the reported
earnings do not change, the cash flow will decrease. As another
example, take the case of a firm that produces more product than it
sells, a situation that results in the accumulation of inventory.
In such a situation, the inventory will appear as an asset on the
balance sheet, but does not result in profit or loss. Even though
the inventory was not sold, cash nonetheless was consumed in
producing it.
Note also the distinction between cash and equity. Shareholders'
equity is the sum of common stock at par value, additional paid-in
capital, and retained earnings. Some people have been known to
picture retained earnings as money sitting in a shoe box or bank
account. But shareholders' equity is on the opposite side of the
balance sheet from cash. In fact, retained earnings represent
shareholders' claims on the assets of the firm, and do not
represent cash that can be used if the cash balance gets too low.
In this regard, one can say that retained earnings represent cash
that already has been spent.
Shareholder equity changes due to three things:
Net income or losses
Payment of dividends
Share issuance or repurchase.
Changes in cash are reported by the cash flow statement, which
organizes the sources and uses of cash into three categories:
operating activities, investing activities, and financing
activities.
Cash Cycle
The duration of the cash cycle is the time between the date the
inventory (or raw materials) is paid for and the date the cash is
collected from the sale of the inventory. A company's cash cycle is
important because it affects the need for financing. The cash cycle
is calculated as: days in inventory + days in receivables - days in
payablesFinancing requirements will increase if either of the
following occurs:
Sales increase while the cash cycle remains fixed in duration.
Increased sales increase the value of assets in the cycle.Sales
remains flat but the cash cycle increases in duration.
While financially it makes sense to reduce the length of the
cash cycle, such a reduction should not be done without considering
the impact on operations. For example, one must consider the impact
on customer and supplier relations as well as the impact on order
fills rates.
Revenue, Expenses, and Inventory:A firm's income is calculated
by subtracting its expenses from its revenue. However, not all
costs are considered expenses; accounting standards and tax laws
prohibit the expensing of costs incurred in the production of
inventory. Rather, these costs must be allocated to inventory
accounts and appear as assets on the balance sheet. Once the
finished goods are drawn from inventory and sold, these costs are
reported on the income statement as the cost of goods sold (COGS).
If one wishes to know how much product the firm actually produced,
the cost of goods produced in an accounting period is determined by
adding the change in inventory to the COGS.
Assets
Assets can be classified as current assets and long-term assets.
It is useful to know the number of days of certain assets and
liabilities that a firm has on hand. These numbers are easily
calculated from the financial statements as follows:
Accounts Receivable (A/R)
Number of days of A/R = ( accounts receivable / annual credit
sales ) ( 365 ).
This also is known as the collection period.
Inventory Number of days of inventory = ( inventory / annual
COGS ) ( 365 ).This also is known as the inventory period.On the
liabilities side:
Payables
Number of days of accounts payable = ( accounts payable / COGS )
( 365 ), assuming that all accounts payable are for the production
of goods. This also is known as the payables period.
Financial Ratios
A firm's performance can be evaluated using various financial
ratios. Ratios are used to measure leverage, margins, turnover
rates, return on assets, return on equity, and liquidity.
Additional insight can be gained by comparing ratios among firms in
the industry.
Bank Loans
Bank loans can be classified according to their durations. There
are short-term loans (one year or less), long-term loans (also
known as term loans), and revolving loans that allow one to borrow
up to a specified credit level at any time over the duration of the
loan. Some revolving loans automatically renew at maturity; these
loans are said to be "evergreen."
Sources and Uses of Cash
It can be worthwhile to know where a firm's cash is originating
and how it is being used. There are two sources of cash: reducing
assets or increasing liabilities or equity. Similarly, a company
uses cash either by increasing assets or decreasing liabilities or
equity.
Sustainable Growth
A company's sustainable growth rate is calculated by multiplying
the ROE by the earnings retention rate.
Firm Value, Equity Value, and Debt Value
The value of the firm is the value of its assets, or rather, the
present value of the unlevered free cash flow resulting from the
use of those assets. In the case of an all-equity financed firm,
the equity value is equal to the firm value. When the firm has
issued debt, the debt holders have a priority claim on their
interest and principal, and the equity holders have a residual
claim on what remains after the debt obligations are met. The sum
of the value of the debt and the value of the equity then is equal
to the value of the firm, ignoring the tax benefits from the
interest paid on the debt. Considering taxes, the effective value
of the firm will be higher since a levered firm has a tax benefit
from the interest paid on the debt. If there is outstanding
preferred stock, the firm value is the sum of the equity value,
debt value, and preferred stock value, plus the value of the
interest tax shield.
The debt holders and stock holders each have a claim on the cash
flows of the firm. In a given time period, the debt holders have a
claim equal to the interest payments during that period plus any
principal payments that are due. The stock holders then have a
claim equal to the unlevered free cash flow in that period plus the
cash generated by the interest tax shield, minus the claims of the
debt holders.
Capital Structure
The proportion of a firm's capital structure supplied by debt
and by equity is reported as either the debt to equity ratio (D/E)
or as the debt to value ratio (D/V), the latter of which is equal
to the debt divided by the sum of the debt and the equity.
One can quickly convert between the D/E ratio and the D/V ratio
by using the following relationships:
D / V = ( D / E ) / ( 1 + D / E )
D / E = ( D / V ) / ( 1 - D / V )
Risk Premiums
Business risk is the risk associated with a firm's operations.
It is the undiversifiable volatility in the operating earnings
(EBIT). Business risk is affected by the firm's investment
decisions. A measure for the business risk is the asset beta, also
known the unlevered beta. In terms of the discount rate, the return
on assets of a firm can be expressed as a function of the risk-free
rate and the business risk premium (BRP):
rA = rF + BRP
Financial risk is associated with the firm's capital structure.
Financial risk magnifies the business risk of a firm. Financial
risk is affected by the firm's financing decision. Total corporate
risk is the sum of the business and financial risks and is measured
by the equity beta, also known as the levered beta. The business
risk premium (BRP) and financial risk premium (FRP) are reflected
in the levered (equity) beta, and the return on levered equity can
be written as:
rE = rF + BRP + FRP
Debt beta is a measure of the risk of a firm's defaulting on its
debt. The return on debt can be written as:
rD = rF + default risk premium
Cost of Capital
The cost of capital is the rate of return that must be realized
in order to satisfy investors. The cost of debt capital is the
return demanded by investors in the firm's debt; this return
largely is related to the interest the firm pays on its debt. In
the past some managers believed that equity capital had no cost if
no dividends were paid; however, equity investors incur an
opportunity cost in owning the equity of the firm and they
therefore demand a rate of return comparable to what they could
earn by investing in securities of comparable risk.
The return required by debt holders is found by applying the
CAPM:
rD = rF + betadebt ( rM - rF )
The required rate of return on assets (that is, on unlevered
equity) can be found using the CAPM:
rA = rF + betaunlevered ( rM - rF )
Using the CAPM, a firm's required return on equity is calculated
as:
rE = rF + betalevered ( rM - rF )
Under the Modigliani-Miller assumptions of constant cash flows
and constant debt level, the required return on equity is:
rE = rA + (1-)(rA - rD)(D / E) where is the corporate tax
rate.
The overall cost of capital is a weighted-average of the cost of
its equity capital and the after-tax cost of its debt capital. The
weighted average cost of capital (WACC) then is given by: WACC = rE
(E / VL) + rD (1-)(D / VL)
Assuming perpetuities for the cash flows, the weighted average
cost of capital can be calculated as:
WACC = rA [ 1 - (D / VL)]
Neglecting taxes, the WACC would be equal to the expected return
on assets because the WACC is the return on a portfolio of all the
firm's equity and all of its debt, and such a portfolio essentially
has claim to all of the firm's assets.
For arbitrary cash flows, and under the assumption that the debt
to value ratio is held constant, the following relationship derived
by James A. Miles and John R. Ezzell is applicable: WACC = rA - rD
(D / VL)(1+rA) / (1+rD)
Under the same assumptions, the cost of equity capital can be
calculated from rA and rD using the following relationship from
Miles and Ezzell:
rE = rA + [ 1 - rD / (1+rD)] [ rA - rD ] D/E
For low values of rD, [ 1 - rD / (1+rD)] is approximately equal
to one, and the expression can be simplified if high precision is
not required.
If one cannot assume a constant debt to value ratio, then the
APV method should be used.
Estimating Beta
In order to use the CAPM to calculate the return on assets or
the return on equity, one needs to estimate the asset (unlevered)
beta or the equity (levered) beta of the firm. The beta that often
is reported for a stock is the levered beta for the firm. When
estimating a beta for a particular line of business, it is better
to use the beta of an existing firm in that exact line of business
(a pure play) rather than an average beta of several firms in
similar lines of business that are not exactly the same.
Expressing the levered beta, unlevered beta, and debt beta in
terms of the covariance of their corresponding returns with that of
the market, one can derive an expression relating the three betas.
This relationship between the betas is:
betalevered = betaunlevered [ 1 + (1 - ) D/E ] - betadebt(1- )
D/E
betaunlevered = [ betalevered + betadebt(1- ) D/E ] / [ 1 + (1 -
) D/E ]
The debt beta can be estimated using CAPM given the risk-free
rate, bond yield, and market risk premium.
Unlevered Free Cash Flows
To value the operations of the firm using a discounted cash flow
model, the unlevered free cash flow is used. The unlevered free
cash flow represents the cash generated by the firm's operations
and is the cash that is free to be paid to stock and bond holders
after all other operating cash outlays have been performed.
Terminal Value
The value of the firm at the end of the last year for which
unique cash flows are projected is known as the terminal value. The
terminal value is important because it can represent 50% or more of
the total value of the firm.
Three Discounted Cash Flow Methods for Valuing Levered Assets
APV (Adjusted Present Value) Method
The APV approach first performs the valuation under an unlevered
all-equity assumption, then adjusts this value for the effect of
the interest tax shield. Using this approach,
VL = VU + PVITS
where VL = value if levered
VU = value if financed 100% with equity
PVITS = present value of interest tax shield
The unlevered value is found by discounting the unlevered free
cash flow at the required return on assets. The present value of
the interest tax shield is found by discounting the interest tax
shield savings at the required return on debt, rD.
The APV method is useful for valuing firms with a changing
capital structure since the return on assets is independent of
capital structure. For example, in a leveraged buyout, the debt to
equity ratio gradually declines, so the required return on equity
and the weighted average cost of capital change as the lenders are
repaid. However, when calculating the terminal value it may be
appropriate to assume a stable capital structure, so in calculating
the terminal value in a leveraged buyout situation the WACC method
may be a better approach. Flows to Equity Method
The flows to equity method sums the NPV of the cash flows to
equity and to debt.
Then, VL = E + D WACC Method The WACC method discounts the
unlevered free cash flow at the weighted average cost of capital to
arrive at the levered value of the firm.
Cash Flows to Debt and Equity
When calculating the amount of cash flowing to debt and equity
holders, it is not appropriate to use the unlevered free cash flows
because these cash flows do not reflect the tax savings from the
interest paid. Starting with the UFCF, add back the taxes saved to
obtain the total amount of cash available to suppliers of
capital.
Hurdle Price
At times a firm may wish to know at what price it would have to
sell its product for a particular investment to have a positive net
present value. A procedure for determining this price is as
follows:
Express the operating cash flow in terms of price. There may be
multiple phases such as a short start-up period, a long operating
period, and a final year in which the terminal value is calculated.
Write out the expression for the NPV using the appropriate discount
rate. For the longer operating period, one can calculate an annuity
factor to multiply by the operating cash flow expression. Solve the
expression for the cash flow that would result in an NPV of
zero.
Since the operating cash flow was written in terms of price, the
price now can be found.
Debt Valuation
While debt may be issued at a particular face value and coupon
rate, the debt value changes as market interest rates change. The
debt can be valued by determining the present value of the cash
flows, discounting the coupon payments at the market rate of
interest for debt of the same duration and rating. The final
period's cash flow will include the final coupon payment and the
face value of the bond.
Investment Decision
If the unlevered NPV of a project is negative, aside from
potential strategic benefits, the project is destroying value, even
if the levered NPV is positive. The firm always could benefit from
the tax shield of debt by borrowing money and putting it to other
uses such as stock buybacks.
Optimal Capital Structure
The total value of a firm is the sum of the value of its equity
and the value of its debt. The optimal capital structure is the
amount of debt and equity that maximizes the value of the firm.
Share Buyback
If a firm has extra cash on hand it may choose to buy back some
of its outstanding shares. One interesting aspect of such
transactions is that they can be based on information that the firm
has that the market does not have. Therefore, a share buyback could
serve as a signal that the share price has potential to rise at
above average rates.Mergers and Acquisitions
Companies may combine for direct financial reasons or for
non-financial ones such as expanding a product line. The target
firm usually is acquired at a premium to its market value, with the
hope that synergies from the merger will exceed the price premium.
Mergers and acquisitions do not always achieve their goals, as
promised syngeries may fail to materialize.
Compounding and Discounting
Compound annual growth rate (CAGR): ( FV/C )1/T - 1
Continuous compounding: FVt = C er t
Perpetuity: PV = C / r
Growing perpetuity: PV = C / ( r - g )
T-year annuity (T equally spaced payments): PV = ( C / r ) [ 1 -
1/(1+r)T ]
T-year growing annuity: PV = [C / (r - g)] { 1 - [(1+g) /
(1+r)]T }
